Profitability Index, Formula, Advantages, Disadvantages

The Profitability Index (PI), also known as the Benefit-Cost Ratio or Value Investment Ratio, is a capital budgeting technique used to evaluate the relative attractiveness and efficiency of investment projects. It is defined as the ratio of the present value of future cash inflows to the initial investment outlay. Mathematically, PI = PV of Cash Inflows / Initial Investment. A PI greater than 1.0 indicates that the project’s present value of benefits exceeds its cost, signifying it will create value and is acceptable. A PI less than 1.0 suggests value destruction. While closely related to Net Present Value (NPV), PI provides a relative measure of profitability (return per rupee invested), making it particularly useful for ranking projects under conditions of capital rationing, where the goal is to select the mix of projects that yields the highest total NPV from a limited capital budget.

Profitability Index (PI) = Total present value/Net cash outlay

It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.

PI = PV cash inflows / Initial cash outlay

Decision Rules of Profitability Index (PI)

1. If projects are independent

Accept the project when PI is higher than 1.

Reject the project when PI is less than 1.

2. If projects are mutually exclusive

Accept the project which has higher PI.(PI must be greater than one)

Reject other project.

In above calculation, project B should be selected because it has higher PI.

Advantages of Profitability Index (PI):

• Useful in Capital Rationing

Profitability Index is very useful when a company has limited funds and many projects to choose from. It shows the value created per rupee invested. Projects with higher PI are preferred because they give more return for each unit of investment. In India, where capital is often limited, PI helps managers select projects that maximise overall value. It ensures efficient use of scarce funds and avoids investing in low-return projects. This makes PI an important tool for effective capital budgeting under financial constraints.

• Considers Time Value of Money

Profitability Index is based on discounted cash flows, so it considers the time value of money. Future cash inflows are discounted to their present value using the cost of capital. This makes PI more accurate than traditional methods like payback period. In India, where inflation and interest rates affect future values, considering time value is important. PI helps managers make realistic investment decisions by properly valuing future benefits. This improves the quality and reliability of capital budgeting decisions.

• Helps in Project Ranking

Profitability Index helps rank different projects based on their profitability. Projects with PI greater than one are accepted, and higher PI projects are given priority. This makes comparison between projects easy, even when their investment sizes differ. Indian companies use PI to arrange projects in order of preference. This supports better planning and selection of projects, especially when multiple investment options are available. Proper ranking ensures that the best projects are chosen to improve overall profitability.

• Supports Value Maximisation

Profitability Index focuses on value creation. A PI greater than one means the project adds value to the business. This helps companies select projects that increase shareholder wealth. In India, firms aim to maximise long term value, and PI supports this goal. By rejecting projects with PI less than one, managers avoid investments that reduce value. This ensures that funds are used only in profitable activities, supporting growth, stability, and better financial performance.

• Simple and Easy to Understand

Profitability Index is simple to calculate and easy to understand. It uses present value of cash inflows and initial investment, which are already calculated in NPV analysis. The result is expressed as a ratio, making it easy to interpret. Indian students and managers find PI user-friendly compared to complex methods. Its simplicity encourages its use along with NPV and IRR. Easy understanding helps in quick decision making while maintaining accuracy in investment evaluation.

Disadvantages Of Profitability Index (PI):

• Not Suitable for Mutually Exclusive Projects

Profitability Index may give wrong results when projects are mutually exclusive. A project with higher PI may have lower total profit compared to another project with lower PI but higher investment. In such cases, PI ignores the absolute value of returns. Indian companies making large investment decisions may face confusion if they rely only on PI. NPV is more reliable in such situations because it shows total value added. Therefore, PI should not be used alone when choosing between mutually exclusive projects.

• Depends on Accurate Cash Flow Estimates

PI is based on future cash inflows, which are estimates. If these estimates are wrong, the PI result will also be incorrect. In India, business conditions often change due to market demand, competition, and government policies. This makes cash flow forecasting difficult. Incorrect estimates can lead to acceptance of poor projects or rejection of good ones. Hence, PI is only as reliable as the accuracy of cash flow projections used in the calculation.

• Sensitive to Discount Rate

Profitability Index depends on the discount rate used to calculate present value. A small change in the discount rate can change the PI value significantly. In India, interest rates and cost of capital change frequently, affecting PI results. If the wrong discount rate is chosen, the project may appear profitable or unprofitable incorrectly. This sensitivity reduces the reliability of PI and makes careful selection of discount rate very important for correct decision making.

• Ignores Project Size in Absolute Terms

PI shows return per rupee invested but ignores the total size of the project. A small project may have a high PI but contribute less total profit. A large project with slightly lower PI may add more value overall. In India, where firms aim for growth and scale, this limitation is important. Relying only on PI may lead to selection of smaller projects that do not maximise total profit. Hence, PI should be used along with NPV.

• Complex for Small Businesses

Although PI is simpler than some methods, it still requires calculation of present value and cost of capital. Small businesses in India may lack technical knowledge or financial expertise to calculate PI accurately. This limits its practical use for small firms. Many small businesses prefer simpler methods like payback period. Due to this complexity, PI may not be widely used at all levels of management. Proper understanding is required to avoid wrong interpretation and poor investment decisions.